Caps, baskets can determine how much of a purchase price you keep

Michael Ellis is a partner in the corporate practice group of Porter Wright Morris & Arthur LLP in Cleveland. He focuses his practice in mergers and acquisitions, partnership agreements, and venture capital transactions.

Most buyers and sellers of businesses believe the purchase price is the most important term of the agreement between parties. There are, however, other terms that are of equal import. This blog, which focuses on how much of the purchase price the seller is able to keep, will be the first of a series focusing on critical, non-purchase-price terms.Almost all sellers of privately held businesses recognize they need to provide representations and warranties relating to the business to be sold to the buyer. They also recognize they will be asked to indemnify the buyer for breaches of such representations/warranties. Limiting the amount of the purchase price subject to indemnity claims, as well as establishing a threshold amount below which the buyer assumes responsibility, are important features in the sale negotiations.The “cap” is the maximum amount a buyer can claim against a seller for breaches of representations and warranties. Fundamental representations, such as those relating to ownership of the assets being sold, authority to sell the assets and taxes, are generally excluded from a cap. Also excluded are claims based on intentional fraud committed by the seller. Certain representations such as environmental matters may have their own cap. Most other representations, such as those regarding employee claims, customer claims or violations of OSHA or other laws, are subject to caps. There is no average cap; each transaction is unique. Distressed businesses or those with significant liabilities are likely to have larger caps, due to the higher probability of claims against a buyer of the business. There are numerous negotiating issues in any transaction and tradeoffs occur. A seller may be willing to provide a larger cap in exchange for a higher purchase price or favorable resolution of other issues.Some purchase agreements are silent as to an indemnity cap. In those cases, it is possible that claims against sellers could exceed the purchase price. If the indemnity obligation extends personally to the business owner of the business sold, such owner could end up both with no proceeds and no business. This scenario, however unlikely, illustrates the importance of establishing a cap. In my opinion, the cap should never exceed the purchase price.A “basket” is the threshold level of claims a buyer is willing to accept before seeking indemnity. Most transactions have a basket of between 0.1% and 1.0% of the purchase price. Thus, on a $5 million purchase price, a 1% basket is $50,000. The logic is, had this liability been known at the time the sale price was determined, the buyer would not have altered the purchase price. There are two types of baskets: a “deductible” and a “dollar one.” A “deductible” basket means that the buyer will accept the economic impact of claims up to the deductible amount, and the seller is responsible for claims over such limit. “Dollar one” provisions makes the seller liable for all claims if the claim amount exceeds the threshold. For example, utilizing a $50,000 deductible basket, the seller would be liable for only $8,000 if the claim was $58,000, but the seller would bear liability for the entire $58,000 if a dollar one basket had been utilized. Under both approaches, the buyer would assume the entire claim amount if the claim was only $48,000.There are numerous surveys prepared by investment bankers and bar associations that aggregate data on terms of purchase agreements. I often provide my clients with such surveys so they can understand the possibilities. While I emphasize there are no standard terms — because every business and sale is unique and all terms are negotiable — the mean “cap” under one recent study was just below 15% of the purchase price and the “basket” was “pegged” at 0.7%. Smaller transactions generally have higher caps and lower baskets than larger transactions. Regardless of what numbers you, as a seller or buyer, elect to utilize, it’s important you are aware of these issues.

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